Shooting Stars

The following commentary was written by Jim Parker, Regional Director, DFA Australia Limited

It is not often appreciated by ordinary investors, but there is a cosy relationship between the media and the brokerage industry. They both want you to believe that certain individuals have uncanny powers of divination.

For stock analysts, promoting the illusion of omnipotence is helpful because it justifies their fees and keeps people trading. For the media, the myth that certain remarkable individuals can reliably forecast stock prices is helpful because it provides endless "gee whiz" stories to keep the ads apart.

Just look at The Australian Financial Review's recent annual supplement on the StarMine Awards¹. StarMine is a research company that measures the performance of stock analysts based on the returns of their buy/sell recommendations and the accuracy of their earnings estimates.

Every 12 months, the newspaper publishes lots of colourful league tables and profiles of that year's "guru" analysts, interwoven of course with paid advertisements helpfully placed by the winning institutions.

Never mentioned is what the league tables showed last year or the year before — because to do so would be to recognise that the accuracy record of the forecasters rarely extends beyond a 12-month period.

For instance, in the 2009 list of top 10 stock pickers, only one individual was also in the 2008 roll of honour. Likewise, in the 2008 list, there was only one name that appeared the year before.

The question arising from all this is just what are investors supposed to do with these league tables? Building portfolios around the stock calls of this year's shooting stars would appear to be a hazardous business given the limited chance of them appearing on the following year's top 10.

Indeed, even the AFR appears to be becoming sceptical about the worth of these annual awards. In an article accompanying this year's supplement, the paper quotes fund managers as saying that sell-side stock analysts had failed to prove their worth in the global financial crisis.

"For most of the past year, the analysts have all been chasing their tails," the paper quotes one fund manager as saying. "They were all trying to be as bearish as possible until March. And then people suddenly started to chase the market up."

Another fund manager was more forthcoming in his criticism: "Generally, analysts have collectively been totally useless during the past 12 months," he told the AFR. "As a payer of institutional brokerage, you do wonder some days what you are paying for."

An interesting theory emerges in the article about why stock forecasters are becoming less useful to long-term investors. Apparently, an increasing chunk of their commission revenue is coming from hedge funds, whose horizon rarely extends beyond the next three to six months.

This extreme short-term focus causes them to make increasingly poor calls, often second and third guessing themselves as fresh information comes to light. In volatile times, as we have seen in the past year or two, this behaviour leads analysts to end up playing catch-up with the market. So why bother?

And that's really the point. No matter how smart individual stock analysts may be, no matter how much they know about the companies and sectors they follow, no matter how much shoe leather they wear out trudging from briefing to briefing, they are in the end hostage to unforseen events:

The government changes the rules around telecommunications, global steel prices collapse, the discovery of new technology renders a previously innovative IT solution obsolete, a breakdown in an obscure area of the mortgage market unleashes a global firestorm in the banking industry...

Making investment forecasts is a haphazard business, and an unnecessary one. Good investment management is not about making forecasts or being on first name terms with the CEOs of listed companies. Good investment management is about understanding and managing risk.

It is about building diverse portfolios around risk factors that have a long-term relationship to return. It is about being mindful about costs and taxes — two things within the control of the investor.

Most of all, it is about recognising what we don't know and managing for that. The bad news is none of us knows what the future will hold. The good news is we don't need to in order to have a successful investment experience.

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¹StarMine Awards, The Australian Financial Review, Nov 27, 2009

This material may refer to resident trusts offered by DFA Australia Limited. These resident trusts are only available in Australia. Nothing in this material is an offer or solicitation to invest in these resident trusts or any other financial products or securities. All figures in this material are in Australian dollars unless otherwise stated.

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